Many income investors prefer not to take on too much market risk. Although dividend-paying stocks offer the potential for growth as well as regular income, they also come with the risk of total loss that comes with owning shares of common stock. That's why some investors turn to preferred stock, which often has higher dividend yields and less exposure to the ups and downs of the stock market. Preferred stock has risks of its own, but in bear markets, it often outperforms common stock while maintaining an advantage on the dividend front. Below, we'll look more closely at this type of stock and the preferred dividends that investors can receive by owning it.
What is preferred stock?
Preferred stock is a hybrid security that combines certain aspects of regular stock with other aspects of bonds. The stock is called "preferred" because shareholders who own it have the first claim on dividend payments before common shareholders can receive dividends. That doesn't mean that a company can't suspend preferred dividends, but it does mean that if it does so, it also has to suspend its common dividends to regular shareholders as well. Preferred shareholders also get the first claim to assets in the event of corporate liquidation, typically being entitled to the full amount of their preference before common shareholders get anything.
In practice, preferred stock trades more like a company's bonds than like a regular stock. That's because the trade-off for the preferred dividends is that the stock doesn't share in the growth potential of the business. Most preferred stock has a defined redemption value that closely resembles a bond's face value, and it sometimes also has a fixed redemption date that looks like a maturity date for a bond.
Because of this, owning preferred stock can be a good way to reduce stock market risk. Typically, if a company has issued both common and preferred stock, the preferred stock will outperform the common stock during bear markets. By contrast, the common stock typically outperforms preferred stock when the stock market is bullish. That's a trade-off that many investors are willing to make for a portion of their portfolios.
It's important to understand, however, that preferred stock is not risk-free. Because it tends to trade in line with corporate bonds, the same factors that hurt bond prices can also affect a preferred stock.
For example, when prevailing interest rates in the economy rise, the prices of preferred stock tend to fall. That's because investors can look for other fixed-income investments that reflect the newly updated higher rate and thus pay more income. That makes an existing bond or preferred stock look less attractive, so investors aren't willing to pay as much on the open market to buy it.
Preferred stock is also vulnerable to changes in the financial condition of the company that issues it. For instance, if a company slips into financial trouble, then investors won't be as confident that it will be able to repay its preferred shareholders by a scheduled redemption date. Moreover, a company that is short on cash can choose to suspend its preferred dividends, cutting off the income stream that investors were counting on.
Finally, be sure that you understand the specific features of the preferred stock in which you're looking to invest. Some preferred stock is also structured with a conversion option, which allows the holder to convert shares of preferred stock into a certain number of common shares of the same company under specified situations. Convertible preferred stock trades much more like a common stock than a nonconvertible preferred stock. So if you're looking to eliminate market risk, then convertible preferred stock may not be what you want in your portfolio.
The idea of preferred dividends sounds good to many investors. But before you use preferred stock to diversify your portfolio, make sure you have a grasp on how it works and what risks are involved. Once you're comfortable with the concept, preferred stock can be a great way for income investors to get the dividend income they want without the full risk of the stock market.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
More from The Motley Fool
Most Americans Made Poor Financial Decisions This Holiday Season
Were you one of them?
4 Ways to Save More in Your 401(k) in 2018
Annual 401(k) contribution limits are going up next year, and it pays to take advantage.
How 1 Senator Got a Bigger Tax Break for Families
Pressure led to an increase in a key tax credit. Find out more about it here.